A Tale of Two Hotels
"Though my bottom line is black, I am flat upon my back,
My cash
flows out and customers pay slow.
The growth
of my receivables is almost unbelievable;
The result
is certain – unremitting woe!
And I hear
the banker utter an ominous low mutter,
‘Watch
cash flow’.”
-Herbert S. Baily, Jr.
“Money
often costs too much.”
-Ralph Waldo Emerson
Part I:
A Brief History & Overview
In 2013,
Hilton Worldwide went public after having been under private ownership by
Blackstone since the late 2007. Earlier this year, Blackstone
exited their position in Hilton Worldwide completely. Bloomberg is calling it “the best
leveraged buyout ever.” Back in 2007, Hilton Hotels Corp CEO, Stephen
Bollenbach, said that the decision to have Hilton bought out by Blackstone
would be the best opportunity to “maximize shareholder value.” Of course,
history has told us that a leveraged buyout is never done because a business is
doing well, so “maximizing shareholder value” was merely a guise for something
more ominous.
Hilton’s
last annual before the buyout, 2007, shed some light. While operating cash
flows on the surface appeared to be very positive and growing ($548M, $486M,
and $652M in 2004, 2005, and 2006 respectively), it was line items in investing
and financing activities that gave cause for concern. Proceeds from asset
dispositions were providing unsustainable cash flows ($1B in 2005, $1.45B in
2006), and borrowings, while they didn’t play much of a role before 2006, were
ramped up to $2.6B during 2006. There was also a $1.5B increase in revolving
loans.
But there
was one item in particular that was waving a red flag: an enormous $5.46B
outflow of cash in investing activities from an acquisition. Let me say that
again: five and a half billion dollars. That’s nothing to sneeze at.
In the
footnotes, Hilton’s management warns us in one line: “We are more highly
levered as a result of the HI acquisition.” During 2006, Hilton Hotels Corp
(what Hilton Worldwide was called back then) acquired Hilton International. Farther
back into the footnotes, we find that because of the HI acquisitions, Hilton
Hotels entered into new senior credit facilities, from $1B to $5.75B like the
drop of a hat. A 2007 news article further mentions that Hilton’s indebtedness
was financed with $20.6B of mortgage and mezzanine debt financing.
This
acquisition was the hay barrel that broke the camel’s back. Not soon after,
Blackstone started showing some interest in Hilton, and the rest is history.
It was Mark Twain who once said, “history doesn’t
repeat, but it does rhyme.” This time around, the demise will be more subtle as
debt payments begin to creep up in the coming years. Unless of course, Hilton
Worldwide decides to do just one more “diworseification.”
Before I get into the details, just upon first
glance, we already see comparisons to Hilton Hotels in 2006/7. Earnings to
fixed charges in 2004-2006 were 2.2x, 3.1x, and 2.3x respectively. In 2018,
EBIT covers interest a measly 3x, roughly the same as it was before. In most
respects, the Hilton situation is a replica of 2007 Hilton, with a little more
cash on the balance sheet. But what’s $500M really when you’re up against
billions in debt?
Part II: Cash Flow
Analysis – Past & Present
I’ll be analyzing Hilton’s cash flow in two
ways: the first through a multiple-year excess cash margin, and the second
through a detailed multiple-year FCF worksheet.

What I’ve done above is adjust reported
operating cash flow and operating earnings for non-recurring and non-operating
items. By subtracting the two, and dividing by revenue, I can see how it
trends. It’s not about it being negative as much as it is about how negative it
gets. By 2006, ECM declined had declined from -4% to -7%, which is almost
double in three years. What this means is that earnings were growing much
faster than operating cash flow. We can see similar trends happening today. By
2017, ECM was -9% from -5% in 2015. Looking at adjust OCF, it almost halved
between 2016 and 2017, while adjusted earnings increased slightly. The takeaway
from this is that it tells us that we should look further. There’s probably a
cash flow problem somewhere.
To pinpoint where, we look at FCF detailed
over the three years.

In this version of deriving operations cash
flow from 2004-2006, we see an almost identical trend to reported operating
cash flows: positive and increasing. Cash flow after debt service doesn’t look
much different either, except for 2006. The highlighted LT debt line shows a
sudden $1.3B cash outflow, which causes 2006 cash flow to venture into negative
territory where it stays before external financing. Now here’s the kicker.
After external financing, cash flow is suddenly out of the hole and a positive
$2.3B, all thanks to LT debt financing (a.k.a. increased senior credit
facilities). Despite the artificial financing, the HI acquisition knocks cash
flow back into the hole, $3.1B deep. So, the trend we see in the end is
positive and growing, up until 2006, when the pendulum swings and breaks from
the acquisition, which can’t be covered, even by financing.

Part III: The Marriott
Dis-analogy
Upon re-reading You Can Be a Stock Market
Genius, it became very apparent that Hilton Worldwide since 2015 may be the
complete opposite of Marriott back in 1993. Marriott International spun-off
Host Marriott towards the beginning of what would become a 10-year expansion.
Hilton Worldwide spun-off Park Hotels and Hilton Grand Vacation at what may be
the end of a 10-year expansion.
In 1993, Host Marriott received all of
Marriott International's debt and the headache of hotel properties while
Marriott International got the lucrative management fees with very little debt
(most of which was structured so that it was convertible into common equity).
Despite being left with consistent revenue
streams from management & franchise contracts, the parent, Hilton Worldwide
has still managed to burn through half its cash on the balance sheet within a
year, and is loaded with long-term debt (roughly 7.7B as of the most recent quarter).
What was the most surprising about Hilton’s
spin-off deal was the management didn’t completely palm off their debt to the
spinoffs. The company still has tremendous leverage. On the other hand,
Marriott made the smarter decision back in 1993 by transferring most, if not
all, of their debt onto Host Marriott.
Part IV: Macro Implications
There has been a noticeable weakening of loan
covenant quality since after the credit crisis of 2008. Most characteristic is
the issuance of covenant-lite levered loans. In 2010, these loans represented
less than 20% of the loan market. In the midst of the boom (2006 and 2007),
they were 25%. In 2018, covenant-lite loans make up approximately 77.6% of the
loan market.